Playing the Name Game—An Update on Cut-Through Clauses
August 2009
In our March 2001 article,
Cut-Through Provisions in Reinsurance
Agreements, we described the nature of cut-through clauses and some of
the business reasons why cut-through clauses exist. In this commentary, we
take another look at cut-through clauses and how they have been interpreted
by the courts since 2001.
by Larry
P. Schiffer
Dewey
& LeBoeuf LLP
Because a reinsurance agreement is a contract of indemnity between a
ceding insurer and a reinsurer, a contractual relationship exists only
between those two parties. Generally, no privity of contract is enjoyed by
the original insured (or reinsured in a retrocessional relationship), as it
has no contract with the reinsurer.
The exception to this general rule occurs when the reinsurer and the
ceding insurer contract around the lack of privity between the original
insured and the reinsurer by express language in the reinsurance contract.
This language in a reinsurance contract is known as a "cut-through" clause.
A cut-through clause allows a party that is not in privity with the
reinsurer to have rights against the reinsurer as a part of the agreement
between reinsurer and ceding insurer.
The Cut-Through Clause
A cut-through clause is generally tailored to respond to specific events
written into the reinsurance contract. It allows the original insured to
take direct action against the reinsurer where these specified events
prevent the original insurer from paying the claims of its policyholder (the
original insured). Cut-through clauses can be particularly useful in
situations where, to secure business, the ceding insurer needs to provide
extra assurance to its policyholders. Many large commercial insureds may not
engage an insurer unless they have some assurance that the reinsurer
standing behind the insurer will be liable to the original insured in the
event the ceding insurer is unable fulfill its policy obligations.
Additionally, certain insurance programs are structured in such a way that
the reinsurer is, for all intents and purposes, the real insurer-in-interest
and the ceding insurer is merely fronting the deal. This may happen because
of licensing issues affecting the reinsurer's ability to issue policies in a
given territory, capital constraints, or brand recognition and penetration.
Recent Court Rulings Involving Cut-Through Clauses
While most
states recognize the validity of cut-through clauses, recent caselaw
suggests that cut-through clauses must be precisely tailored in order to be
effective. Indeed, if any language proffered as a cut-through clause is not
precisely worded, courts have shown a clear preference against finding the
clause to be a valid cut-through clause.
An excellent example of how the
courts interpret cut-through clauses is the recent decision in
Jurupa Valley
Spectrum, LLC v. National Indem. Co., 555 F.3d 87 (2d Cir.
2009). In Jurupa, the obligee of surety bonds sued the surety's
reinsurer to collect on the bonds after the surety became insolvent. The
claim arose out of the following language in the reinsurance contract:
[T]he parties to this Reinsurance intend that Reinsurer, through the Claims
Administrator, shall pay all amounts ... due Insureds and other persons as
and when due directly on behalf of the Reinsured....
The obligee argued that
this wording necessarily implied that the reinsurer had granted cut-through
rights to all original insureds against the reinsurer. In affirming the
district court, the Second Circuit Court of Appeals ruled that this clause
did not constitute a cut-through clause. The court stated that "New York law
recognizes an exception if the reinsurance agreement contains a so-called 'cut-through' provision granting policyholders a direct right of action
against reinsurers, which is apparent on its face." Despite the apparent
provision for payment to the original insured, the court found that the
provision needed to specifically name those insureds to which payments would
be made.
This seemingly minor difference was determined to be the
distinguishing factor between the contract in this case and the contract
containing substantively similar language that the court found to be a
cut-through clause in Trans-Resources, Inc. v. Nausch Hogan & Murray, 298 A.D.2d 27 (1st Dept. 2002). The court said the language in
Trans-Resources included the agreement of the reinsurer
"to pay
directly to the named insured," while the language above provided that the
reinsurer "shall pay all amounts due Insureds." This latter language, the
court held, did not specify to whom the payments will be made.
Moreover,
Article 14 of the reinsurance contract provided expressly that:
[n]othing
... expressed or implied,... shall be construed to confer upon ... any
person [other than the parties] ... any rights or remedies under ... this
reinsurance.
This language, said the court, further supported the view
that the reinsurance contract did not provide for a cut-through.
The
specificity the Second Circuit sought, which required the reinsurance
contract to name the direct insured to be paid via a cut-through clause, is
an example of the type of detailed construction required for any cut-through
clause to be effective. While there are differences between the clauses in
Jurupa and Trans Resources, this should not take
away from the importance of careful construction of cut-through clauses to
assure their effectiveness. The court's message in
Jurupa is
clear: particular phrasing of any clause creating additional rights for
third parties in reinsurance contracts is crucial for the validity of the
clause, especially if the wording is to be construed to overcome additional
language in the agreement stating that:
[n]othing [herein], express or
implied, ... shall be construed to confer upon ... any person ... (other
than the parties hereto or their permitted assigns or successors) any rights
or remedies under ... this reinsurance.
Thus, the issue of specifically
naming the insured to be paid in the event of insolvency, and not the
disclaimer language, was the primary issue resulting in the court's finding
that no cut-through clause existed in Jurupa.
Yet, courts
have not backed away from the general rule that reinsurance contracts can
still effectively contract around the traditional tenet that there is no
right of the original insured against the reinsurer. Rather, the decision in
Jurupa serves to advance the idea that, to allow the original
insured rights against a reinsurer, a clear intent must be manifest in the
specific language of the contract itself.
In Trans-Resources, the reinsurer attempted to use fairly standard language to avoid an alleged
cut-through clause. The reinsurance contract had a provision stating that
the reinsurer "shall have no obligation to the original insured or anyone
claiming under the policy(ies) reinsured." The court, however, refused to
overlook language in the contract's cover note obliging the reinsurer "to
pay directly to the named insured ... with respect to any claim under said
policy" and stating that this clause "stipulates direct liability and
creates a direct procedural privity as between the original insured and the
reinsurer."
When you compare Trans-Resources to
Jurupa,
it becomes clear that the major difference between the wordings
of the purported cut-through clauses in both cases is the specificity in
which the party receiving the reinsurance payments was named. The court in
Trans-Resources found that a cut-through clause existed
because the policyholder (the named insured) was clearly named as the
recipient of direct payments from the reinsurer if the ceding insurer could
not pay. Although this clause represented a fairly standard "insolvency
clause" that is found in many reinsurance contracts, the decision in
Trans
Resources indicates the importance of specific construction of
cut-through clauses by expressly naming the policyholder that will be paid
upon the ceding insurer's default.
The specificity of naming the party to whom direct payments will be made
is often based on statutory requirements. For example, in Pennsylvania, the
statute provides that:
The amount
recoverable by the liquidator from reinsurers shall not be reduced as a
result of delinquency proceedings, regardless of any provision in the
reinsurance contract or any other agreement. Payment made directly to and
insured or other creditor shall not diminish the reinsurer's obligation to
the insurer's estate except where the reinsurance contract provided for
direct coverage of an individual named insured and the payment was made in
discharge of that obligation.
40 P.S. § 221.34.
This statute formed the
basis for the guidelines established by the court supervising the Reliance
Insurance Company liquidation in Pennsylvania. See Koken v. Reliance Ins.
Co., No. 269 M.D. 2001 (Apr. 26, 2002). These guidelines set
forth the circumstances under which direct payments by reinsurers to insureds would be allowed—essentially the rules for determining the validity
of cut-through clauses for reinsurers of Reliance.
In Koken v. Legion Ins.
Co., 831 A.2d 1196 (Pa. Commw. 2003), the court noted the
Reliance guidelines were instructive in considering cut-through clauses in
the Legion Insurance Company insolvency, but were not binding. In
Koken v.
Legion, the court addressed several claims by several insureds
claiming direct access to reinsurance proceeds. One insured claimed that the
reinsurance contract between the ceding insurer and the reinsurer had an
express cut-through right. The insolvency clause in the reinsurance contract
provided as follows:
... The reinsurance will be payable by the Reinsurers
directly to [the cedent], its liquidator, receiver, ... except (a) where
this Agreement specifically provides another payee of such reinsurance in
the event of ... insolvency or (b) where the Reinsurers, with the consent of
the direct insured or insureds, have assumed such policy obligations of [the
cedent] as direct obligations of themselves to the payees under such
policies in substitution for [the cedent's] obligation to such payees. Then,
and in that event only, [the cedent] ... is entirely released from its
obligation and the Reinsurers will pay any loss directly to the payees under
such policies.
The court found that the reinsurer functioned as the direct
insurer (it was a fronting situation) and that provision (b) was included in
the reinsurance contract to provide the insureds direct access to the
reinsurers in the event of the ceding insurer's insolvency. The rationale
behind the cut-through provision in the insolvency clause, as expressed by
the court, was to give the insureds comfort that if something happened to
the insurer, the insureds would be able to obtain coverage directly from the
reinsurers.
In rejecting the rehabilitator's attempt to give very narrow
meaning to the exception provision in § 221.34, the court in
Koken v. Legion stated that it is difficult to make any generalizations about
cut-through endorsements and how they ought to appear. Expert testimony
cited by the court acknowledged that cut-through clauses are distinctive and
vary depending on the jurisdiction and the intent of the parties.
Conclusion
It is clear from the ruling in Jurupa that
the precise wording of a cut-through provision must clearly indicate its
function in allowing a third party to the reinsurance contract the right to
direct access to the reinsurance, as well as sufficiently naming the party
to who payment will be made. Yet, jurisdictional differences, statutory
distinctions, and the intent of the parties may allow for enforcement of a
cut-through clause that does not meet the Jurupa standards. If
what the parties intend is that the underlying insured should have direct
access to the reinsurance should the ceding insurer become insolvent, then
the provision should be drafted precisely and clearly to effect that intent.
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